Money: Don't give up on the 'sleepy' trusts

Despite their bad press, investment trusts still have plenty to offer, says Philip Middleton

If I were an investment trust, I'd be talking to my analyst. Virtually every article about the trusts recently has slammed them as "under-performing", "sleepy", "fusty" or "struggling". Two funds have been set up simply to pick on the strugglers. Hostile shareholders are circling, uttering war cries such as "shareholder value"' and "restructure now".

Before prescribing either Prozac or hemlock, it is worth looking at the facts. Investment trusts as a whole have risen in value by nearly 20 per cent between the end of 1993 and the end of September 1997. Over the same period, the UK stock market has risen by almost 50 per cent.

The UK has been a strongly performing market, but trusts as a whole have had at least half their own investments outside the UK. The Japanese and Far East stock markets have fallen, and trusts as a whole have been heavily biased towards these areas (largely because this was where investors wanted to invest). Trusts as a whole are also heavily committed to smaller companies in the UK. Notoriously, "small caps" have underperformed the stock market.

So, many of the problems are down to where trusts have been invested: not enough UK banks, too many Asian stocks. Fleming Japanese, a well-run trust, has never had a chance of beating the UK market.

Another chunk of underperformance is down to the widening of the "discount" - the difference between investment trusts' share prices and the value of their underlying investments (called net asset value). At the end of 1993 the sector was trading on as narrow a discount as I have ever seen, around 3 per cent. Now it has widened to around 12 per cent.

I believe it is the discount that really grates with investors - people who bought into new trusts in late 1993 will have seen, on average, 15 per cent wiped off the value of their investments by movements in the discount.

What's worse, many new issues focused on Japan, the Far East and emerging markets. Because of this, you do not have to look hard to find new issues of this vintage which have more than halved.

How have trusts reacted? First, the market for new trusts is shut for all bar highly specialist vehicles. If you believe, as I do, that too much supply leads to price weakness, this is good news. In addition, the sector has started to return cash to investors. If a trust is trading on a discount of 15 per cent, and its assets can be sold easily, then turning it into an open-ended fund (like a unit trust) gives investors a quick one-off boost. What's more, some of this money flows back into other, similar investment trusts, boosting their ratings.

The first big return of capital in the sector this time around came with the ill-starred Kleinwort European Privatisation Trust (Kepit). Launched at the start of 1994, it attracted more money than any trust in history: pounds 880m. It also seemed to attract more odium than any trust in history. This was not so much because it performed particularly badly, but because the gap between what people expected and what they got was so huge. More recently, Mercury European (which has performed well at the portfolio level), has announced plans to buy in 15 per cent of its shares, while Fleming Far Eastern has returned 70 per cent of its assets to shareholders. A number of smaller funds have followed suit, and we expect this will continue until ratings narrow.

So what should the poor investment trust shareholder do? First of all, let's not have too much of the "poor". For example, someone who has held Foreign and Colonial for the past 20 years has beaten the UK stock market usefully, and cash massively. People who have held trusts for shorter periods, and especially those who have bought the 1993-94 splurge of new issues, should ask themselves two questions: "do I want to be invested in Asia/Japan/wherever" and "has the trust I have invested in performed poorly". If the answers to these questions are "yes" and "no" respectively, the best advice usually is to sit tight. Overall, I believe the sector looks good value at the moment, and investors should not let their pique about recent performance obscure this.

What if you have not yet invested in investment trusts? The wrong option is simply to buy funds on big discounts, hoping for a takeover. There may be reasons for wide discounts, and restructuring is still haphazard. I believe that much the better option is to find a well-run trust investing in an area you like the look of, and look to exploit the discounts on offer.

The big picture is clear. Investment trusts as a whole are not "fusty" or "struggling"; they are just cheap.

q Philip Middleton is an investment trust analyst at stockbrokers Merrill Lynch.


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